Behavioral Finance

New Financial DNA Developments for Addressing Risk Tolerance

Risk tolerance is a much talked about area in financial planning and it is one core component of an investor’s unique financial behavior – what we call their Financial DNA. It is so fundamental that we are always talking about it and making decisions with reference to it.

A huge difficulty has been reliably measuring an investor’s risk tolerance. One of the problems is that an investor’s risk tolerance is assessed today but then a portfolio is developed for the long term which has to cope with fluctuating markets. Do you truly know what your client’s risk tolerance for the long term is? How much of your assessment of the client’s risk tolerance is based on current situational factors and their emotional impulses today about the market? Then add in the fact that a person’s risk tolerance may differ across different asset classes. Of course, an advisor’s own risk tolerance can color the situation resulting in the client “eating” the behavior of the advisor. There have been lots of examples where a group of advisors addressing the same case facts at the same time will come up with different risk tolerance assessments for the client.

After more than 10 years of studying financial behaviors, including risk, and performing research based on our online profiles Financial DNA Resources has now launched our “Behavioral Portfolio Report”. You can download a copy of it here:

The Behavioral Portfolio Report provides a comprehensive and holistic analysis of a person’s complete financial behavioral style resulting in the creation of what we call an “Inside-Out Portfolio”. The inside-out portfolio gets to the level of asset classes and also tactical factors for investment selection. This then becomes the foundation for the financial plan and investment policy statement.

Fundamental to the Inside Out Portfolio is a superior analysis and quantification of the person’s risk perception and risk attitude. In particular, our analysis uniquely dissects their:

1. Understanding of risk and return – if this is high then they are likely to see investment markets as less risky
2. Risk propensity to take risks (or be bold) – their behavioral inclination to make daring or bold choices
3. Risk tolerance – which is the ability to live with the consequences of taking risks

Interestingly, our research has shown that in 20% of cases people have a higher risk propensity than risk tolerance. This is critical for advisors to know as their client could take greater risks than they can stomach.

Core to our Financial DNA work has been the discovery of a person’s natural “hard-wired” behavior – these are the behaviors that remain stable through a client’s life. This applies equally to risk propensity and risk tolerance.

Recently, we have had people re-take our profiles to determine profile consistency with time gaps of over 3 years. The consistency level has been very high which is powerful considering the turbulent times we have been living in.

It is key to know a client’s natural risk profile for building a portfolio as this is the behavior which will reveal itself when they are under pressure and generally throughout their life. This behavior is highly predictable. However, you do need to know the client’s current financial preferences as well based on experiences and education. This will tell you where they are at now and how much portfolio variance they can accept, and what additional guidance they may need in the portfolio construction phase.

So, our view is that you cannot know enough about your client when you are advising them. Knowing all of the dimensions of the client’s risk attitudes and objectively quantifying them is important for the “know your client rules” and more importantly to be able to have a transparent discussion with your client to properly manage their expectations. Using your intuition is very important but it alone is not enough. Now is the time to start educating your clients with much deeper and applied behavioral insight.

Global Transition for High Net Worth Individuals

I have just read KPMG’s Swiss Financial Services Newsletter for August 2008. The newsletter provides very sharp insights into the increasingly complex international needs of high net worth individuals. The outcome is that the consulting team will need to have a greater global outlook and more sophisticated approach to the technical and human issues impacting the HNWI client.

Some of the key trends driving the changes in how HNWI’s need to be serviced are:

  1. Investments of HNWI’s are continuing to become more global and diversified
  2. Stronger demand for superior life quality resulting in lifestyles taking on a growing international flavor
  3. Family members living and working internationally away from the home base
  4. HNWI’s want their consultants to play a collaborative role – working with them, not for them
  5. Demand for a higher set of values including ethically correct behavior, social recognition and reputation

Specifically for the consultant this will mean their service model needs to meet the following requirements for the HNWI:

  1. Capability to deal with many different legal and tax jurisdictions, which means increased complexity and recognition of cross border issues
  2. A personal approach and outlook which is cross cultural and able to adapt to diverse human requirements
  3. Focus on comprehensive, customized solutions with a holistic perspective that take into account the concerns of the HNWI, short and long term goals in life and multi-generational family issues
  4. Clearly understand their vision and be able to anticipate their unique needs
  5. Understand them in the context of a larger relationship which encompasses both family and business matters
  6. Provide a single point of contact with access and the ability to coordinate a worldwide, comprehensive network of professionals
  7. Be free from conflicts of interest and exercise absolute independence
  8. Innovatively deliver and implement best in breed solutions
  9. Have systems that assure complete security and confidentiality
  10. Provide the reliability of a recognized brand name

I definitely believe this is the new world order for HNWI services. Very few can do it individually. Great collaboration will be needed to be successful.

Personally, over the past 10 years my approach to this has been to play the role of “brains trust” to HNWI’s by firstly understanding who they are at a deep level. Then as part of this role, be the independent sounding board to deal with the complex issues and bring in the right specialists as and when needed.

Partnerships and Money Personalities

In the past few weeks we have had a number of people contact us who are starting some form of business partnership together. Most of the time their request has been to find out more about their differences. Some of the typical issues they are seeking to understand are:

1. What are our different talents?
2. What should our role in the business be?
3. What areas do we have to watch out for?
4. Do we have shared values and purpose?
5. Who else should we hire?
6. How do we communicate with each other?
7. How do we hold each other accountable?

These are all very important questions and it is important they are always addressed in structuring and managing a partnership.

However, there is another dimension that needs to be understood and is seldom directly addressed. That is the influence of different money personalities.

1. What are the different money personalities of each of the partners?
2. What is each partner’s different relationship to money?

In essence, we need to know their DNA Behavior. How will each partner behave with money based on their financial behavioral style? This is absolutely critical to the success of the partnership. So often partnerships do not work or certainly fail to reach their potential because of the different financial attitudes. The different financial attitudes will have a large bearing on their respective goals, what each wants from the business, how they will handle money in the business, how the business is financed and the business development plans. You will even find the financial attitudes of the spouses will be important as this is another partnership to which each of the business partners is accountable and is strongly influenced by.

If one partner is more dominant, then his or her financial attitude will prevail and have a strong influence on the outcome of the business and the decisions. It is my experience from working with many partnerships, and first hand from being in partnerships, that each partner having a healthy relationship to money will be foundational to success. Just have a look at some partnerships that you know of that have worked and failed. Ask why? Money is nearly always there in a big way. Do not be afraid to find out the answers early as this will save a lot of pain later. This is important as having shared values and knowing your respective talents. If not understood, it will become a major road block.

Changing Lives with Powerful Questions

Today, I listened to a great presentation by Tal Ben-Shahar who teaches positive psychology at Harvard University. Interestingly, his 2 courses have been rated the most popular in the university. No wonder, he is so motivating.

The message he delivered was that if you want to change the reality of people’s lives then you need to change the questions you ask them. The right questions can change people’s lives. This is when miracles happen.

Think about when your life changed or you made a major change in your life. Was it because someone asked you a great question? Very often it is. I know many of my significant life choices have been prompted by a great question. Furthermore, I remember the people who asked me these life changing questions.

How do you ask these life changing questions, or what we call in our business powerful questions? They must be positive or what is often referred to as appreciative. Always come from a positive angle or the person’s strength, regardless of what the situation is.

If you want to be more structured or scientific about it, then you can have the person complete a behavioral profile first. Then you know their areas of strengths and interests to which the questions can be directed.

The same approach can be followed with a person in any area of your life: whether it be clients, team mates or family members.

Know Thy Investments

The primary foundations of Financial DNA are “Know Thyself” and Know Thy Client”. However, what I have not spoken up much before about is “Know Thy Investments”. For both the advisor and the client this is absolutely critical to successful investing. Who at some point has been caught in an investment they did not fully understand and lost money? Usually, they are the “smart” investments that offer lucrative returns and/or tax breaks.

In recent times, I have had discussions with many advisors and investors who have been caught with an investment that they did not fully understand. You should forgive yourself because even the best investors have been caught at some point. This point is not just about “ponzi schemes” but also bona fide investments.

Market declines like we have had in the past year usually expose the cracks. When the market is going up the holes can often be covered up. Some of these investments are so complex that not even the creator or manager even understands them fully, let alone the advisor recommending it.

I have always said to my clients: “If you do not know what is inside the sausage do not invest”. Until a year or so ago, I did have some doubts as to whether I had been too conservative and that I was the fool for not riding the trend. Well now I am very relieved. A good example of this advice was 5 years ago when I told a very wealthy retired couple not to invest in a hedge fund that they had been offered by someone who was trying to impress them.

I do not believe most people know what they have invested in other than the belief they will make a lot of money. Many hedge funds rely on very complex models and very fine margins. Also, many change their strategy after you have invested. So that what you have invested in is not underneath the same investment as what you exit. I also know that many investors and advisors did not understand how leveraged with debt our financial markets were. All of these complex products usually have a lot of debt in them. So when the market declines, the fall can be accelerated because everyone has to get out quickly.

If you are an investor, now is a great time to review all of the investments in your portfolio and check that you truly understand them. Also, does your advisor understand your investments? Can your questions be confidently answered? I also think advisors need to take stock and totally understand what they are offering their clients. You really need to get behind the “research” reports.

Understanding Client DNA Behavior Under Pressure

When I was a financial planner and even before that a CPA, I had regularly observed that people’s behavior and decision-making patterns changed when they were under pressure; the pressure often being caused by money and relationships. This observation was fundamental to my thinking when I was building the Financial DNA Discovery Process with my team. We wanted to know what a person’s natural instinctive behaviors are as this would be key to predicting how they would really behave when there were difficult times and/or difficult decisions had to be made.

This plays into the research we recently did of 100 advisors with AUM over $50million. 70% of them said that they were surprised by their clients reactions. Why? Well, it is the natural DNA behavior taking over based on genetics and our very early life experiences which shape the neural pathways in the brain. In the good times, we all operate out of learned behaviors based on experiences, education and values. Hence, we have a greater chance of managing our emotions in favor of rationality. Under pressure, that switches.

It was interesting to read the Wall Street Journal Article on Saturday April 4 by Jason Zweig titled: “Influence of DNA on Your Investing Style in Troubled Times”. Whilst different methodologies were used to discover this DNA behavior than we use, the conclusion is much the same. Zweig made the following point based on his own interview with Dr. Ahmid Hariri at the University of Philadelphia: “There is always a tug of war inside each of us between nature and nurture. But during scary times like these, says Dr. Hariri, “environmental stresses can play a critical role in unmasking any underlying biases determined by your genes.” In other words, bear markets give nature the upper hand. It is now harder than ever to stick to the disciplines that can override your genetic impulses, but it also has never been more important”.

So, now more than ever is the time to truly discover your client’s DNA behavior and help them from the inside-out to achieve higher financial life performance.